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Understanding the Roles of Speculators and Hedgers in Futures

What are speculators?

Speculators are primary participants in the futures market. A speculator is any individual or firm that accepts risk in order to make a profit. Speculators can achieve these profits by buying low and selling high. But in the case of the futures market, they could just as easily sell first and later buy at a lower price.

Obviously, this profit objective is easier said than done. Nonetheless, speculators aiming to profit in the futures market come in a variety of types. Speculators can be individual traders, proprietary trading firms, portfolio managers, hedge funds or market makers.

Individual traders

For individuals trading their own funds, electronic trading has helped to level the playing field by improving access to price and trade information. The speed and ease of trade execution, combined with the application of modern risk management, gives the individual trader access to markets and strategies that were once reserved for institutions.

Proprietary trading firms

Proprietary trading firms, also known as prop shops, profit as a direct result of their traders’ activity in the marketplace. These firms supply their traders with the education and capital required to execute a large number of trades per day. By using the capital resources of the prop shop, traders gain access to more capital than they would if they were trading on their own account. They also may have access to the same type of research and strategies developed by larger institutions.

Portfolio or investment managers

A portfolio or investment manager is responsible for investing or hedging the assets of a mutual fund, exchange-traded fund or closed-end fund. The portfolio manager implements the fund’s investment strategy and manages the day-to-day trading. Futures markets are often used to increase or decrease the overall market exposure of a portfolio without disrupting the delicate balance of investments that may have taken a significant effort to build.

Hedge funds

A hedge fund is a managed portfolio of investments that uses advanced investment strategies to maximize returns, either in an absolute sense or relative to a specified market benchmark. The name hedge fund is mostly historical, as the first hedge funds tried to hedge against the risk of a bear market by shorting the market. Today, hedge funds use hundreds of different strategies in an effort to maximize returns. The diverse and highly liquid futures marketplace offer hedge funds the ability to execute large transactions and either increase or decrease the market exposure of their portfolio.

Market makers

Market makers are trading firms that have contractually agreed to provide liquidity to the markets, continually providing both bids and offers, usually in exchange for a reduction in trading fees. Market makers are important to the trading ecosystem as they help facilitate the movement of large transactions without effecting a substantial change in price. Market makers often profit from capturing the spread, the small difference between the bid and offer prices over a large number of transactions, or by trading related futures markets that they view as being priced to provide opportunity.

Conclusion

All types of speculators bring liquidity to the market place. Providing liquidity is a crucial market function that enables individuals to easily enter or exit the market. Though speculative trading activity generates considerable liquidity, all market players benefit. In contrast to speculators who aim to profit by assuming market risk, some buyers and sellers have a vested interest in the underlying asset of each contact. These market participants aim to offset or eliminate risk and are referred to as hedgers.

What is a hedger?

Hedgers are primary participants in the futures markets. A hedger is any individual or firm that buys or sells the actual physical commodity. Many hedgers are producers, wholesalers, retailers or manufacturers and they are affected by changes in commodity prices, exchange rates, and interest rates. Changes to any of these variables can impact a firm’s bottom line when they bring goods to the market. To minimize the effects of these changes hedgers will utilize futures contracts. Unlike speculators who assume market risk for profit, hedgers use the futures markets to manage and offset risk.

Corn hedger example

Let’s look at an example of a corn farmer. In the spring, the farmer is concerned about the price for his crops when he sells in the fall. If prices drop at harvest, the farmer will have to sell the crop at a lower price.

One way the farmer could hedge his exposure would be to sell a corn futures contract. When harvest rolls around and the price of corn drops, he will see a loss in price when he sells his crop in the local market, however that lose would be offset by a trading gain the futures market. If prices rallied at harvest, the farmer would have a trading loss in the futures market but his crop would be sold at a higher price in the local market.

In either scenario, the hedged farmer has added protection against adverse price movements. The use of futures enabled him to establish a price level well before the he sells the crop in his local market.

Types of hedgers

There are several types of hedgers in the commodities markets:

Buy-side Hedgers: Concerned about rising commodity prices

Sell-side Hedgers: Concerned about falling commodity prices

Merchandisers: They both buy and sell commodities. Their risk is different than the directional risk of a traditional buying and selling hedger. Their risk is the spread or difference between the purchase and selling prices that determines their profitability.

Summary

Many industries now use the risk management potential of futures contracts for a variety of assets. The profitability of a construction company partially depends on the cost of building materials. By purchasing a steel futures contract, the firm is able to secure a price at which it acquires steel. Conversely, steel mills worried about a decline in building demand and the drop in steel prices can sell steel futures contracts to protect against that price movement.

Airlines now hedge against rising fuel costs through the use of crude oil futures. And jewelry manufacturers can hedge against gold and silver price movement by utilizing precious metals futures contracts.

When it comes to hedging, there are a variety of market participants who buy and sell physical commodities, and they may benefit from the added price protection offered by futures and options contracts.

The comments, views, and opinions expressed in the presentation are those of the CME Group. The content presented is intended for informational purposes only. Neither Charles Schwab Futures, Inc., nor Charles Schwab & Co., Inc., endorse nor can make a representation as to the accuracy, timeliness or completeness of the information presented.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against trading losses.

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